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How to Play the Lululemon Athletica Earnings Announcement
This article was submitted to Seeking Alpha but was declined because it focused on options. I thought you might like to see it.
This quarter’s earnings season is winding down. Only one company with weekly options available, Lululemon Athletica (LULU) is due to report next week. (I restrict my analysis to companies with weekly options because they are the most actively-traded and popular, and I often employ the weekly options in my trading.) LULU reports on Monday, June 10 after the closing bell.
LULU is a high-end retailer of fitness apparel including fitness pants, shorts, tops, and jackets for healthy lifestyle activities, such as yoga, running, and general fitness. Based in Vancouver, British Columbia, LULU has 135 stores in the United States and 51 stores in Canada, and also has extensive wholesale business through health and fitness clubs.
Not only are its clothes high-end, so is its p/e ratio, 42.47, which compares to Nike’s (NKE) 24.11. This lofty evaluation is the likely reason for the large number of shares sold short (19.8% of the float).
Looking forward to next week’s earnings announcement, let’s check out what has happened over the past four quarters, with the stock price change from the close on the day before the announcement until the closing price on Friday (when the weekly options expire):
LULU has not done very well after earnings announcements considering they beat estimates every time. In half the quarters the stock fell after they topped estimates. The stock has tended to move considerably after an announcement (an average of 7%). Next week’s option prices are priced for a 7% move, exactly the average change for the last four quarters.
Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves. I call it the Expectation Model. Basically, I examine recent stock price activity, estimates vs. whisper numbers, past post-earnings price changes vs. results, current RSI levels, and come up with a measure of whether expectations are unusually high or low.
If expectations are usually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met. (Unusually low expectations are generally less predictive of higher post-announcement prices, however – unusually high expectations more reliably predict lower prices after the announcement).
I have had some serious success with this model, including 12 consecutive winning pre-earnings calls (average gain about 18%) without a loss – see results and update. Over half of the earnings plays were published in Seeking Alpha articles published before the announcement – see some examples here and here.
A bullish case for the company cited getting its yoga pant line back after recalling it for being too transparent - Lululemon Poised To Pop After Ironing Out Pants Issue. A more balanced analysis was made by Bill Maurer – Will Lululemon Decline After Earnings? I strongly encourage you to read this article as he reported just about exactly what I would have said so there is no reason to repeat it all here.
The only thing I would add to Bill Maurer’s article is my concern of the level of recent insider and institutional sales of stock. While Yahoo reports that insiders sold 579,758 (4.2% of their holdings) over the past six months, if you add up the individual sales reported that number becomes more than double that amount. Over the last quarter, institutions disposed of over 7 million shares (4.9%) of their holdings.
So how does LULU stack up with the Expectation Model? Bottom line, expectations seems to be a little high leading up to next week’s announcement. The stock has had a huge run-up recently, rising about 25% over the past 10 weeks and hitting a new high of $82.48 last week before backing off about $4 since then. Whisper numbers are higher ($.32) than estimates ($.30).
Recent institutional sales or purchases are part of the model and have been a fairly reliable indicator as to how the price might move after the announcement. We can expect that a great deal of research and analysis went into their decision (in this case, to sell shares) and it is usually a good idea to follow along with them rather than guess they are wrong.
High expectations, a record of lower stock prices after earnings, and what I believe is a currently-expensive stock price, all lead me to believe that there is an excellent chance that LULU will trade lower next week and that anyone who is thinking of buying shares should wait until after the announcement and most likely get a better price at that time. This is just what I said about Costco (COST) two weeks ago (a company I love and am long), and even though it bested estimates, it is trading about $5 lower after announcing.
I don’t feel as strongly that LULU will drop after the announcement as I did with COST, however (mostly due to the stock falling $4 in the last week), so I will hedge my bet. With LULU trading at $79, I will buy 10 July-13 80 calls and sell 10 Jun2-13 78.5 calls (incurring a maintenance requirement of $2500) for about even money, and buy 5 July-13 – Jun2-13 82.5 call calendar spreads for about $1.25 (just in case I am wrong and the stock moves higher). My total investment will be about $3200.
Here is the risk profile graph for those positions assuming that IV of the July option will fall from 40 to 30 after the announcement:
These positions could make an average gain of about 20% if the stock does not fluctuate too much. It looks like a gain of some sort should come about if the stock fluctuates by less than 5% on the upside or about 7% on the downside. This is an investment you should only make with money that you can truly afford to lose. I plan to do it, and expect it to be my 13th consecutive winning earnings trade.
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Terry
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